How To Find the Best ETFs

This article explains how I determine the best ETFs in the 25 reports I publish each quarter on the Best & Worst ETFs and mutual funds by sector and style. Here is the 4Q Best & Worst preview. I follow these steps:

There are several simple and free screens to perform the first step and cull out ETFs that should be avoided.

As long as you focus on the ETFs from issuers that have a market cap of at least $100 million, you are likely working with ETFs that are successful enough to garner serious assets. So, you can assume their tracking error is respectable and liquidity is high enough that you will not get thrown under the bus by the bid/ask spread.

Now comes the hard part: picking the ETF with the best holdings. Contrary to the screens above, there are very few services that evaluate the quality of the holdings of an ETF.

Research on holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance. No matter how cheap, if it holds bad stocks, the ETF’s performance will be bad.

PERFORMANCE OF ETF’s HOLDINGs = PERFORMANCE OF ETF

You cannot rely on the ETF label/name to accurately reflect the ETF’s holdings. ETFs with the same label often have radically different holdings. See Barron’s “The Danger Within”.

I only recommend the top three ETFs in this sector: Health Care Select Sector SPDR (NYSE: XLV), iShares Dow Jones U.S. Health Care Index Fund (NYSE: IYH) and Vanguard Health Care ETF (NYSE: VHT) because they get my 4-star or better rating. I do not recommend investors buy any ETFs with a 3-star rating or lower.

Figure 1: Top 10 Health Care ETFs

Sources: New Constructs, LLC and company filings

My ETF rating also takes into account the total annual costs, which represents the all-in cost of being in the ETF. This analysis is simpler for ETFs than funds because they do not charge front- or back-end loads and transaction costs are incurred directly. There is only the expense ratio, which is normally quite low. However, my ratings penalize those ETFs with abnormally high expense ratios or any other hidden costs.

The best large cap value ETF is WisdomTree Dividend ex-Financials Fund (NYSE: DTN). Only two other ETFs in this sector, iShares High Dividend Equity Fund (NYSE: HDV) and PowerShares Dynamic LargeCap Value (NYSE: PWV), earn my 4-star or Attractive rating. All the rest get my 3-star or Neutral rating and should be avoided.

The stock that shows up consistently in the top health care and large cap value ETFs is Johnson & Johnson (NYSE: JNJ). This stock gets my Very Attractive rating. JNJ has a return on invested capital (ROIC) of 17%, which places it in the top quintile of all companies. Usually that kind of profitability comes at a price. In this case, the valuation of JNJ’s stock price implies the company’s profits will permanently decline by 26%. XLV’s large allocation to a highly profitable, yet undervalued stock, exemplifies why XLV is one of the few ETFs that gets a Very Attractive rating.

Another stock that shows up often in the top health care and large cap value ETFs is Verizon (NYSE: VZ). VZ’s ROIC is not super high but its economic earnings growth in its last fiscal year was nearly 100% versus negative growth in reported accounting earnings. And the valuation of the stock is cheap. Its current stock price (~$46.50/share) implies the company’s profits will permanently decline by about 30%. High profit growth and low valuation create excellent risk/reward in a stock.

Disclosure: I own JNJ and VZ. I receive no compensation to write about any specific stock, sector or theme.